6. Costs, revenues, and profit
- Introduction
- o Looking at different types of behavior of firms in relation to the markets in which they operate and the nature of competition in different markets
- Cost Theory
- o The short run and long run
- § Short run: the period of time in which at least one factor of production is fixed. All production takes place in the short run
- § Long run: the period of time in which all factors of production are variable, but the state of technology is fixed. All planning takes place in the long run
- § To increase output (in the short run), firm needs to apply more units of the variable factors to the new quantity of the fixed factors
- o Total, average and marginal product
- § Total product (TP): Total output that a firm produces, using its fixed and variable factors in a given time period.
- § Average product (AP): Output that is produced, on average, by each unit of the variable factor;
(TP is the total output produced, V is the number of units of the variable factor employed)
- § Marginal product (MP): extra output that is produced by using an extra unit of the variable factor;
- o The law of diminishing returns
- § The hypothesis of eventually diminishing marginal returns: as extra units of a variable factor are added to a given quantity of a fixed factor, the output from each additional unit of the variable factor will eventually diminish
- § The hypothesis of eventually diminishing average returns: as extra units of a variable factor are added to a given quantity of a fixed factor, the output per unit of the variable factor will eventually diminish
- o Economic cost
- § Economic cost: economic cost of producing a good is the opportunity cost of the firm’s production
- § To work out the economic cost of production, separate the factors used by firms
- 1. Factors that are purchased from other and not already owned by the firm: opportunity cost of factors of production not owned by the firm is the price that is paid and the alternative things that could have been bought; explicit costs: any costs to a firm that involve the direct payment of money
- 2. Factors that are already owned by the firm: opportunity cost involved in their use which needs to be accounted for; implicit costs: earnings that a firm could have had if it had employed its factors in another use or if it had hired out of sold them to another firm
- o Short-run costs
- § Firms have different costs when producing, can explain the different ways of measuring costs, tends to separate costs into two groups
- Total costs: total costs are the complete costs of producing output (use 3 measurements)
- o Total fixed cost (TFC): TFC is the total cost of the fixed assets that a firm uses in a given time period; constant amount and is equal to the number of fixed assets
- o Total variable cost (TVC): TVC is the total cost of the variable assets that a firm uses in a given time period; increases as the firm uses more of the variable factor and is equal to the number of variable factors
- o Total cost (TC): TC is the total cost of all the fixed and variable factors used to produce a certain output; equal to TFC + TVC
- Average costs: costs per unit of output (3 measures)
- o Average fixed cost (AFC): AFC is the fixed cost per unit of output; constant, falls as output increases, equal to
- o Average variable cost (AVC): AVC is the variable cost per unit of output; falls as output increases and start to rise again as the output continues to increase, equal to
- o Average total cost (ATC): ATC is the total cost per unit of output; falls as output increases and start to rise again as the output continues to increase, equal to AFC + AVC, calculated by
- o Marginal cost (MC): MC is the increase in total cost of producing an extra unit of output; falls as output increases and start to rise again as the output continues to increase, calculated by
- o Relationship between curves: MC cuts AVC and ATC at their lowest points, gap between ATC and AVC gets smaller as output grows
- o Average fixed cost (AFC): AFC is the fixed cost per unit of output; constant, falls as output increases, equal to
- o Total fixed cost (TFC): TFC is the total cost of the fixed assets that a firm uses in a given time period; constant amount and is equal to the number of fixed assets
- Total costs: total costs are the complete costs of producing output (use 3 measurements)
- § Firms have different costs when producing, can explain the different ways of measuring costs, tends to separate costs into two groups
- o The short run and long run
- o Long-run (planning stage)
- § Long-run: the long run is that period of time in which all factors of production are variable, but the state of technology is fixed. All planning takes place in the long run.
- § Long-run average cost curve (LRAC): envelops an infinite number of short-run average cost curves (SRAC)
- § Why long-run costs increase/decrease as output increases
- Economies of scale:any decreases in long-run average costs that come about when a firm alters all of its factors of production to increase its scale of output; lead to firm’s increasing returns to scale
- o Specialization: managers that have to take on many different roles; lead to higher unit costs; as firms grow, they are able to have their management specialize in individual areas of expertise (production, finance, marketing)
- o Division of labor: breaking a production process down into small activities so workers can work repeatedly and efficiently
- o Bulk buying: large firms negotiating discounts with suppliers (small firm would not have received)
- o Financial economies: large firms can raise financial capital (money) more cheaply than small firms; banks charge a lower interest rate to larger firms
- o Transport economies: large firms making bulk orders may be charged less for delivery costs than smaller firms
- o Large machines: large firms have large machineries
- o Promotional economies: large firms with high outputs don’t need to promote their products
- Diseconomies of scale: any increases in long-run average costs that come about when a firm alters all of its factors of production to increase its scale of output
- o Control and communication problems: large firms have harder time to control and coordinate the activities of the firm, which leads to inefficiency; large firms needs effective communication
- o Alienation and loss of identity: workers in large firms lose sense of belonging and loyalty, which makes them work less hard and less productive
- External economies and diseconomies of scale: group of economies and diseconomies that come about when the size of the whole industry increases and this has an effect on the unit costs of the individual firms
- Economies of scale:any decreases in long-run average costs that come about when a firm alters all of its factors of production to increase its scale of output; lead to firm’s increasing returns to scale
- o Final notes on cost theory
- § Short-run cost curves are U shaped because of the hypothesis of diminishing returns
- § Long-run cost curves are U shaped because of the existence of economies and diseconomies of scale
- Revenue Theory
- Revenue: Income that a firm receives form selling its products, goods, and services over a period of time
- o Measurement of revenue
- § Total revenue (TR): total amount of money that a firm receives from selling a certain amount of a good or service in a given time period; calculated by
- § Average revenue (AR): revenue that a firm receives per unit of its sale; calculated by
- § Marginal revenue (MR): extra revenue that a firm gains when it sells one more unit of a product in a given time period; calculated by
- § Total revenue (TR): total amount of money that a firm receives from selling a certain amount of a good or service in a given time period; calculated by
- o Revenue curves and output
- § 1. Revenue when price does not change with output (elasticity of demand is infinite)
- Theoretical situation where firm does not have to lower price as output increases; perfectly elastic demand curve (price, average revenue, marginal revenue, demand are the same)
- § 2. Revenue when price falls as output increases (demand curve is downward sloping/elasticity of demand falls as output increases)
- Firm wish to sell more of its output, lower price to increase demand; AR is equal to price and so it falls as output increases; MR also falls as output increases (more steep); TR rises but eventually falls as output increases
- Relationship between price elasticity of demand, MR, AR, and TP (price increase and demand is elastic à TR will increase; price increase and demand is inelastic à TR will decrease)
- Rules:
- 1. PED is elastic: firm wishing to increase revenue should lower price
- 2. PED is inelastic: firm wishing to increase revenue should raise price
- 3. PED is 1: firm wishing to increase revenue should leave the price unchanged
- § 1. Revenue when price does not change with output (elasticity of demand is infinite)
- o Measurement of revenue
- Profit Theory
- How to measure profit: Total profit = total revenue – economic cost (explicit and implicit costs)
- o The shut-down price
- § If firm temporarily closes down, in the short run and produce nothing, it will only lose its total fixed costs (unavoidable costs like rent, interest, repayments on loans, opportunity cost)
- o The break-even price
- § Price at which a firm is able to make normal profit in the long run (break even and cover all of its costs, including opportunity costs)
- § Level of price that enables a firm to cover all of its costs in the long run (price where price = average total costs,
- o The profit maximizing level of output
- § If MR>MC, firm should increase production
- § If a firm wishes to maximize its profits, it should produce at the level of output where marginal cost (MC) cuts marginal revenue (MR) from below
- § You must remember to make sure that the MC curve cuts the AC curve at the lowest point on the AC
- o Final notes on profit theory
- § Revenue maximization: entrepreneurs attempt to maximize their sales revenue by producing where the marginal revenue is zero; produce above the profit maximizing level of output
- § Growth maximization: companies set targets to achieve growth in the short run (rather than profits) to gain a large market share and dominate the market in the long run; growth is measured by quantity of sales, sales revenue, employment/percentage of market share
- § Satisficing: satisficing is where an economic agent aims to perform satisfactorily rather than to a maximum level, in order to be able to pursue other goals
- § Corporate social responsibility (CSR): this is where a business includes the “public interest” in its decision making; adopting an ethical code that accepts responsibility for the impact of its activities
- o The shut-down price